Investors and Consumers: Don't Panic

Two esteemed economists and a Nobel Prize-winning psychologist argue that cooler heads should -- and must -- prevail

Worries about Wall Street, global markets, and a massive credit crunch have created unnerving volatility in the financial markets; the $700 billion bailout package seems to have done little or nothing to calm investors' nerves. And it looks like more interventions from the U.S. government are on the way.

The question now is: Will the panic move from Wall Street to main street -- and if it does, will it make a bad economic situation worse? "The reality is that your relationship with a financial institution is based on trust," says Gallup Chief Economist Dennis Jacobe. "A lot of people trusted that these big Wall Street investment firms couldn't go broke. As trust erodes, it creates problems."

One of those problems is that average people might take their cues from Wall Street, and right now, the Street is a terrible role model. With trillions of dollars lost in the past year and an estimated loss of at least 110,000 jobs in the financial sector since January 2008, market movers are scared.

"Wall Street is really comprised of greed and fear: greed to get as much as they can and fear that they may lose everything," says Jacobe. "And right now, fear is by far a more dominant feeling. There's a lack of transparency on the Street because no one knows what assets people have, what losses they're going to take, and who's going to be next."

Of course, fear rarely fosters rational behavior. And though behavioral economists would argue that economic transactions are driven more by emotion than we may realize, everyone recognizes that scared moneymen are bound to behave irrationally, which could affect or instruct American investors.

"The psychology is trickling down. It's not the public's fear that makes the difference; what really is important is how worried the financial institutions are," says psychologist Daniel Kahneman, Nobel Prize winner in economics and senior scholar at the Woodrow Wilson School of Public and International Affairs. "I believe that the public will be affected, but I think that whether or not they are afraid doesn't make a difference to the stock market -- unless fear stops us from purchasing things, which it probably will to some extent as confidence goes down."

Americans' rising economic negativity and sinking consumer confidence suggest that Wall Street's psychology is trickling down, and that its panic is starting to affect average consumers. Jacobe says that's a problem. Not only will it stall investment just when the markets most need cash, but worry is also self-perpetuating.

"Fear has a way of building on itself. When the markets are going well, greed and optimism have a way of building positive momentum," Jacobe says. "When fear takes over, it builds negative momentum. This is all emotional. Morgan Stanley reported positive earnings. Everybody says it's a strong company. But people lost faith, and Morgan Stanley's stock price just kept plummeting."

Economist Alan Krueger believes that fear has already caused a 1930s-style run on investment firms. "The reason Lehman Brothers and Bear Stearns fell was because investors lost confidence in them. We're also seeing old-fashioned runs on some banks," says Krueger, Bendheim Professor of Economics and Public Affairs at Princeton University, research associate of the National Bureau of Economic Research, and former chief economist at the U.S. Department of Labor. "Is it a good idea? No. Panic makes financial markets fail."

So this, of all times, is an excellent opportunity to avoid panicking, both for financial sector workers and for consumers. "People who act coolly while other people are acting emotionally will make better decisions," Kahneman says. "But there won't be too many of those."

Another Great Depression?

Yet even if the "Wall Street psychology" gets corked in lower Manhattan, Wall Street's woes will affect U.S. consumers. And it's only sensible to be worried under the circumstances. But how worried should they be? Put another way, no matter how well panic is contained, what's to stop the U.S. market from sinking into another Great Depression? "I think we're just lucky that we have a Fed chairman whose major area of expertise is the Great Depression," says Jacobe. "I never thought I'd say that, but he's the right man at the right place."

Although bank investors could lose money in the short term, savings in FDIC-insured consumer banks or thrifts are temporarily insured up to $250,000 through December 31, 2009. Fannie Mae and Freddie Mac are still operating following a historic takeover by the U.S. government and will continue backing mortgage loans. However imperfect and unpopular last week's $700 billion bailout plan was with American taxpayers, lawmakers did do something, which many observers think was better than taking no action at all.

What's more, while there had been concern expressed about the government's intervention in Fannie Mae, Freddie Mac, and AIG, it was probably the best response -- among a number of bad alternatives -- to the worsening financial crisis. "They've done the right thing," says Jacobe. "The reality is that letting some of these enormous financial firms fail when nobody knows what the financial consequences would be is an unprecedented risk. It's a risk for further financial instability, and that's the closest thing we've experienced to the financial chaos of the 1930s."

Right now, the $700 billion bailout may be the best firewall between a panicked Wall Street and a global financial meltdown. But there's more that government leaders can do to avoid a repeat of a similar crisis in the future.

"The Fed is doing what it can. The Treasury has also been active," says Krueger. "The [U.S.] president needs to take leadership, however, and introduce legislation that increases transparency in derivatives markets and that regulates big investment banks and insurance companies in a way that is commensurate with the public funds that are now at risk if they should fail."

Don't hit that panic button

Though controversial, the government bailout and future interventions may lead toward a long-term solution to U.S. financial woes. However, they don't seem to be assuaging Americans' short-term financial concerns. Kahneman says that the average investor likely will have one of two responses: flee or freeze. Both are risky, as both responses are based on emotion -- and the most prominent current emotion is fear. Fear is a great motivator, but a bad guide. A better strategy is to stay calm.

"A lot of people can't sleep for worry, so they're going to do panicky things, and they'll lose a lot of money," Jacobe says. "Everyone involved in the system has to try and help everybody stay as calm as possible. So let the people on Wall Street do their thing -- let the Treasury, Fed, and the Congress do likewise -- and watch and wait until things calm down before you do anything."